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Accountancy is a very important and essential sector of each and every business whether small or big in size. A sound and smooth business is only possible if there is proper and transparent transaction detailed and thus the need of different financial reports comes in to show the business position at a particular period of time. Therefore, the first step in developing a financial management system is the creation of financial statements.
A financial statement isÂ a written report of the financial condition of a firm. Financial statements include the balance sheet, income statement, statement of changes in net worth and statement of cash flows.
The elements of financial statements are the building blocks for the balance sheet and income statement. The principal elements are as follows:
Gains and losses
1. Income statement
The income statement (also called a profit and loss account) records whether the company's sales revenue is greater than its costs. It allows comparing the latest profit with previous year's profit, or with other companies. It also states what happened to the profit; the proportions that were paid out in tax, in dividends, or retained within the business.
2. Balance Sheet
The balance sheet is a financial statement that reveals the financial condition of a company at a particular point in time, usually the end of a quarter or fiscal year. It is useful to investors because the relationship among different part of the balance sheet provides evidence as to a company's financial strength, which in turn can furnish clues to its future performance. The balance sheet summarizes what a company owns (assets) balanced by what a company owes (liabilities) and to owners of the enterprise (owners' equity or stockholders' equity).
In equation form, the balance sheet is represented as follows:
Assets = Liabilities + Stockholders' Equity
So in whole it can be said that, the balance sheet is a snapshot of what the company owns and is owed on a particular day; usually the last day of the financial year. The balance sheet summarizes the assets and the liability of the business .The difference between the assets and the liabilities is the shareholders' funds.
By definition, the balnce sheet must always balance, meaning assets must always equal liabilities plus stockholders' equity. This relationship is crucial to understanding the balance sheet. For example, if a company has assets of £10 million and liabilities of £8 million, then stockholders' equity will be £2 million. Therefore, an alternative view of the balance sheet equation is to rearrange liabilities:
Assets - Liabilities = Stockholders' Equity
Hence, in reports and accounts, the net income comes from the difference between the asserts and the liabilities.
This form of the equation reflects that stockholders' have a claim to assets only after creditors' claims are satisfied.
The economic resources expected to provide future benefits to the company are called assets. A balance sheet is classified so that similar items are grouped together to arrive at significant subtotals.
Assets are divided into two categories:
Fixed assets: Fixed assets are those that are not held for resale, but for use for the business, and it is generally disclosed for three categories.
Tangible assets: Tangible assets include assets with relatively long lives. These are assets used to earn revenue that have a physical presence. Assets within this category are depreciated over their useful lives. Depreciation is a method of allocating the cost of an asset over its productive life. The total depreciation expense recorded is called accumulated depreciation.
Example: Property, plant and equipment such as land, machinery and vehicles are tangible assets.
Intangible assets: Intangible assets embody valuable rights to the company even though they have no physical substance. Patents for example,provide the holder with the exclusive right to use, manufacture and sell a product or process for a period of 17 years without any interference or infringement by others.
Example: Patents, trademarks, goodwill, franchises, copyrights or other publishing rights, licenses and so on.
Investment: These assets are expected to be last for long term. As being the shareholders for other companies or buying the bonds, insurance, investment funds of other companies. It also can be shown at cost.
Current assets: Current assets are assets that include cash plus other assets expected to be converted into cash within one year. These are the assets used up and replenished continuously in the ongoing operations of the company.
Examples: The most prominent current assets are cash, marketable securities, receivables and inventories.
The definition of liability is a financial obligation, debt, claim, or potential loss, in other words liabilities are economic obligations of a company to outsiders. Liabilities are mainly of two types:
Current Liabilities: Those are usually payable within one year.
Long-term Liabilities: Those usually come due after one year.
To break it down, liabilities can be classified into more elaborating typologies. These various types of liabilities are discussed below:
FixedÂ liability:Â TheÂ liabilityÂ which is to be paid of at the time of dissolution of firm is called fixedÂ liability. Examples are Capital, Reserve and Surplus.
Long-termÂ liability:Â TheÂ liabilityÂ which is not payable within the nextÂ accountingÂ period is called long-termÂ liability. Examples are Debentures of a company,Â Mortgage LoanÂ etc.
CurrentÂ liability:Â TheÂ liabilityÂ which is to be paid of in the nextÂ accountingÂ period is currentÂ liability.. Examples: Sundry, creditors, Bills Payable and Bank overdraft etc.
TradeÂ liability:Â LiabilityÂ which is incurred for goods and services supplied or expenses incurred are called tradeÂ liability. Example: Bill payable and sundry period.
FinancialÂ liability:Â LiabilityÂ which is incurred for financial purposes is called financialÂ liability. Example: Bank overdraft, load taken for a short period.
ContingentÂ liability:Â A contingentÂ liabilityÂ is one which is not an actualÂ liabilityÂ but which will become an actual one on the happening of some event which is uncertain. Examples: Bills discounted before maturity,Â LiabilityÂ of a case pending in the court.
The evolving of the definition of assets in years
Definitions of assets have evolved from a narrow legal orientation to a broader concept of economic resources. The first definition of assets emphasized legal property but also included deferred charges because they relate to future period income statements. This aspect of the definition represents a revenue-expense approach to the financial statements. The second definition emphasized that assets are economic resources. Anything having future economic value was considered an asset. Deferred charges were separately identified in this definition but were still grouped with assets. The third definition identified the key characteristics of an asset as (1) its capacity to provide future economic benefits, (2) control of the asset by the firm, and (3) the occurrence of the transaction giving rise to control and the economic benefits. Deferred charges were dropped from the asset definition. The economic resources approach represents a broader concept of assets than the legal property concept and is consistent with the economic notion that an asset has value because of a future income (cash) stream.
The first definition of liabilities defined them as credit balances that would be properly carried forward upon a closing of books of account according to the rules or principles of accounting, provided such credit balance is not in effect a negative balance applicable to an asset. This definition made no distinction between owners' equity and liabilities, thus implying an entity theory view of the firm. The other two liability definitions do not mention owners' equity, which seems to imply a proprietary view of the firm in which owners' equity represents owners' residual interest in the net assets. The liability portion of the first definition emphasizes legal debts. In the second definition, the liability concept is broadened to mean economic obligations. In addition, deferred credits are identified separately but are still considered to be a part of liabilities. The third and most recent definition continues the emphasis on economic obligations rather than legal debt and drops deferred credits. This definition lists three essential characteristics of an accounting liability: (1) a duty exists, (2) the duty is virtually unavoidable, and (3) the event obligating the enterprise has occurred.
Relationship between balance sheet and income statement
There can be either relations between the income statement and balance sheet or not. As they are all calculating the net income, it's just about how the way for the company to do.
While a balance sheet is a stock-based static statement that presents a company's financial position at a point in time, an income statement is a flow-based dynamic statement that describes a company's operating performance over a period of time. The period covered by an income statement must be clearly specified.ã€€Historically, the income statement used to be a supporting statement to the balance sheet. Without the income statement, we would record revenue as an increase, and expense as a decrease, of the equity account Retained Earnings. Such transactions are numerous. ã€€Depending on how revenues and expenses are presented, there are roughly two formats of the income statement, the traditional multi-step format and the relatively new two-step format. The former has a few steps: Sales - Cost of Goods Sold = Gross Profit; Gross Profit - Operating Expenses = Operating Income; Operating Income Â± Non-Operating Items = EBT (Earnings Before Tax); EBT - Income Tax = Net Income. ã€€Of course whether an item is operating or not depends on the nature of the business. For instance, while Interest Expense may be a non-operating expense for many companies, it is the most important operating expense for banks. ã€€When a company has losses rather than earnings, it does not have to pay income tax. It may also be allowed to carry the loss backward and/or forward, depending on the tax environment the company is in. ã€€Different users of financial statements often have different needs. The multi-step format of the income statement is unlikely to suit all needs. Some American companies took the lead to use the two-step format. In this format, the income statement contains basically two parts. The first part lists all sources of revenues while the second lists all kinds of expenses. A reader can prepare the income statement in any form to suit his purpose. It must be pointed out that the net income shown in the income statement is an accounting profit, not cash flow. In the computation of accounting profit, cash receipts from selling fare cards are not recognized as revenue. Rather, they are "Unearned Revenue" classified under Current Liabilities. Revenue is considered realized only after the bus service is provided and consumed. Similarly, insurance premium paid for any part of the next financial year will not go to the expense in the income statement.